The Time Might be Right for BuyWrite

Even though things looked extremely grim early on, 2009 ended up being a wonderful year to be long in the markets. But, on the heels of a monumental rally that saw major market indexes bounce 70% off their lows, many investors are now beginning to question the sustainability of the market's recovery. With the market's margin of safety narrowing significantly, a healthy degree of caution seems warranted.

Indeed, this a difficult and stressful time for many investors. While recent economic data have shown signs of improvement and provided rays of hope for the bulls, there are still lingering concerns about how the market might react to a withdrawal of government stimulus. Moreover, regulatory risks cannot be ignored, particularly for the health-care, energy, and financial sectors.

With exogenous factors today playing such vital roles in important sectors of our economy, it is difficult to develop conviction in the stock market. Subscribers to Morningstar ETFInvestor are familiar with our preference to pick up yield from relatively conservative industries, but other strategies can help ensure higher returns by giving away some of the upside potential. Some investors might consider trading options around their equity portfolio in order to collect some premiums (and even manage risk).

Covered Calls
One of the more basic (and conservative) option strategies involves selling call options on a security that you already own in your portfolio, and many liquid ETFs have liquid option markets on their underlying products. Using a covered call strategy with an ETF can be a particularly attractive strategy when volatility appears relatively expensive. Co-editor and portfolio manager of Morningstar OptionInvestor pens a weekly article discussing volatility trends. The timely analysis offered in the reports should serve as a valuable resource for option investors.

Recently, when the VIX briefly touched 17, it looked as if the market was being lulled into a sense of complacency. (See our recent commentary here.) However, things reversed course quickly. Investors are getting nervous about the fragility of the economy and how stocks could be impacted once the massive stimulus effects wear off. Investors have a few options, aside from going to cash or joining the bond market stampede.

Rather than selling and running for cover, selling calls can be an excellent way to enhance returns in a sideways trading market. Think of the premiums you collect as extra income. Currently, investors selling calls on the  SPDRs (SPY) with a strike price that's roughly 7% out of the money would be collecting an additional 4% (annualized) on their investment through the call premiums. Of course, if there was a spike in volatility, the annualized premium could rise significantly. Furthermore, you have no downside protection if the S&P 500 falls, and your upside potential would be limited by your strike price.

By rolling contracts month to month and keeping exposures to 30 days or less, an investor would be able to take advantage of rising volatility in the markets. This is a similar concept to the bond investor who manages the duration of his portfolio around movements of interest rates. It swings both ways. So for instance, if we were to experience a sharp rise in implied volatility and options became relatively expensive, an investor could extend his or her exposure out to a year or more to lock in nice fat call premiums.

Of course, options aren't for everyone. Also, each investor's situation is unique. Among things to consider would be the cost basis of the investment being secured by the call options, whether the investor is willing to trigger a taxable event, and so on.

 

Protective Puts
On the other hand, investors who think volatility is still relatively cheap at current levels but also fear another leg down, or a "double-dip" recession, could think about adding some protective puts to their portfolio. Whereas when selling options we target expensive volatility, in cases when we're buying insurance, we want to pay the lowest premiums possible. After all, this is a strategy where you are a buyer of insurance, not a seller of speculation.

So let's take for example an investor who believes the markets are a bit too complacent and that the recovery could be much rockier than many are predicting. One of the potential catalysts they lean on is the result to the economy when (or should we say "if") the government removes the punch bowl--aka withdrawal of stimulus. Those subscribing to such a thesis might consider targeting economically sensitive sectors that stand to be hit the hardest in the event of a serious market correction.

One of the first industries that comes to mind is retail. Weak labor markets, overleveraged consumers, and massively contracting consumer credit have led many to question the sustainability of the recovery. Each of these factors could weigh on discretionary consumer spending going forward. An investor who thinks retail is poised to take it on the chin could look to purchase put contracts on  SPDR S&P Retail (XRT). By keeping a relatively defensive equity profile (i.e. consumer staples) investors could maintain some market beta, while also protecting themselves from a sharp move down with put options on XRT.

The beauty of dealing with options on ETFs is that investors can remove idiosyncratic risks from the equation and focus on broader macroeconomic drivers. We'd encourage those who are interested in learning more about how to incorporate options into their portfolio to check out Morningstar OptionInvestor. Click here to download Morningstar's free guide to option investing.

Cruise Control
There's good news for those of you who found the covered call strategy discussed above appealing, but find investing in options to be a little too intimidating. PowerShares offers two buy-write options strategies: PowerShares S&P 500 BuyWrite Portfolio (PBP) and PowerShares NASDAQ-100 BuyWrite Portfolio . These are both the equivalent of running covered call strategies on the respective underlying indexes. Keep in mind though, that these strategies make the most sense during flat or only moderately rising markets.

The portfolios are relatively new and thus we have limited performance data to analyze. In a market that rose as rapidly as it did last year from the March lows, a covered call strategy would typically underperform. The reason would be that as the market shoots higher, there's a stronger likelihood that your position gets called away and you end up forfeiting some of your upside. Still looking back at 2009, we see that PBP delivered a return of 25% versus about 26% for SPY. (These figures account for the difference in expense ratios between the two funds.) The kicker though, is that PBP did it with a standard deviation (a common measure of risk) of 14% compared with 20% for SPY.

The performance of PQBW was less inspiring, but that's what we would've expected considering tech's strong rally through the recovery. The fund delivered a 44% return with 13% standard deviation last year.  PowerShares QQQ  , however, returned more than 54% in 2009 with standard deviation of about 21%. There are likely investors out there who would gladly sacrifice a few points of return for damped volatility. These funds could be a solid choice for such investors.

As we move through 2010, in what many are expecting to be a "boring" year (at least comparatively) for the equity markets, we think these strategies could actually outperform while also providing less volatile returns. Having such strategies available as ETFs allows some investors to take a hands-off approach, or put it in cruise control.

As an aside, we'll be keeping our eyes peeled to see if put-write strategies can make their way into an ETF wrapper. STOXX recently launched a put-write index on the EURO STOXX 50, but no funds currently track it. The reason a put-write index could be intriguing is that put options typically command higher premiums due to the fact that portfolio managers seek insurance. Being a seller of those premiums should translate into juicier returns for investors (relative to a buy-write strategy).

 

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